Liquid Alternatives

DEFINITION of 'Liquid Alternatives'

Liquid alternative investments (or liquid alts) are mutual funds or exchange-traded funds (ETFs) that aim to provide investors with diversification and downside protection through exposure to alternative investment strategies. These products' selling point is that they are liquid, meaning that they can be bought and sold daily, unlike traditional alternatives which offer monthly or quarterly liquidity. They come with lower minimum investments than the typical hedge fund and investors don't have to pass net worth or income requirements in order to invest.  

Critics argue that "liquid" alts' liquidity will not hold up in more trying market conditions; most of the capital invested in liquid alts has entered the market during the post-financial crisis bull market. Critics also contend that the fees for liquid alternatives are too high. For proponents, though, liquid alts are a valuable innovations, since they bring the strategies employed by hedge funds within reach of retail investors

BREAKING DOWN 'Liquid Alternatives'

An alternative investment is a loosely-defined term that in principle refers to almost any asset that is not a long-only stock or a bond. Examples include fine art, private equity, derivatives, commodities, real estatedistressed debt and hedge funds. A drawback of any of these investments, however, is their lack of liquidity. Under normal market conditions, a $5,000 position in Alphabet Inc. (GOOG, GOOGL) is easy enough to offload in milliseconds without affecting the price. Even if the private equity market is in rude health, however, it will take considerably more time and effort to sell an alternative investment, and there may be lock-up periods. It can also be more difficult to take a small position in alternative investments.

Liquid alts aim to counteract these drawbacks by providing investors with exposure to alternative investments through products that can be redeemed daily just like a mutual fund.

Categories of Liquid Alternatives

As of September 2016, Morningstar, using a universe of 621 funds, has defined 12 categories of liquid alternative strategies. The largest, accounting for over 80% of the funds, are the following:

  • Long-short equity Funds that concentrate on equity securities and derivatives and combine long positions with short bets achieved through ETFs, options, or plain-old short stock positions. The balance of short to long positions will depend on the fund's macro outlook.
  • Nontraditional bond These funds take unconventional approaches to bond investing, often trying to achieve returns that are uncorrelated with the bond market. "Unconstrained" funds invest with a high degree of flexibility, taking positions in high-yield foreign debt, for example.
  • Market neutral Funds that seek to minimize systematic risks born of overexposure to specific sectors, countries, currencies, etc. They aim to match short positions and long positions within these areas and achieve low beta.
  • Managed futures These funds invest primarily through derivatives, including listed and over-the-counter futures, options, swaps and foreign exchange contracts. Most use momentum approaches, while others follow mean-reversion or other strategies.
  • Multialternative These funds combine different alternative strategies, such as those listed above. They may have fixed allocations to set strategies, or vary their approaches depending on market developments.

Other categories include bear-market, multi-currency, volatility and trading-leveraged commodities (the last includes just one fund). Goldman Sachs has devised a different set of categories that more closely parallel strategies commonly employed by hedge funds. Goldman has divided a universe of 326 funds into equity long/short, tactical trading/macro, multistrategy, event-driven, and relative value approaches.

Criticisms of Liquid Alts

The number of liquid alternative funds has mushroomed since the financial crisis, as individual investors and advisors are increasingly eager to protect against downside risk by using hedge fund-like strategies. In a July 2015 survey, Barron's and Morningstar found that 63% of advisors planned to allocate more than 11% of their portfolios to liquid alts within the next five years.

For critics, though, this enthusiasm is misguided. First of all, liquid alt funds charge higher fees on average than other actively managed mutual funds. Second, stuffing illiquid assets into liquid packaging has the potential to backfire. Hedge funds generally require investors to agree to withdraw funds only every quarter or year. The ability to trade in and out of liquid alts has contributed to their popularity, but if a downturn precipitates a run on the funds, providers may be forced to sell assets at sharply discounted prices, and investors may suffer as a result.